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01/27/2008

Tax Burdens-Becker

The burden of taxes to a country depends not only on the fraction of its gross domestic product GDP that are collected as tax revenue ‚Äìthe data shown in Posner's chart- but on many other factors as well. Since my comment is brief I will confine my discussion to the link between tax burdens, the level of government spending, and the structure and incidence of taxes.
It is not possible to separate tax burdens from government spending. Obviously, as Posner makes clear, how governments spend their tax revenues makes an enormous difference to the functioning of an economy. In addition, however, the level of government spending also affects the tax burden. If spending exceeds the amount collected in taxes, the excess spending must be financed by an increase in government debt (I ignore inflationary printing of money). Interest payments on the higher government debt have to be financed by higher taxes in the future, so the full tax burden is determined not by tax revenues alone but also by government spending. Senator McCain has justified his initial opposition to the Bush tax cuts by indicating that they were not combined with cuts in government spending -in fact, just the opposite occurred.
The tax burden depends in addition on the type of taxes used and their structure. What economists call the "excess burden" is measured by the difference between the cost to those paying taxes and the revenue collected by government. The excess burden is zero for a head tax, which is an equal tax per person, since the amounts paid to governments from such a tax equals the cost to taxpayers. Taxes on income do have an excess burden because they distort taxpayers' decisions toward greater leisure. The higher the marginal tax rate, the greater are these and other distortions induced in labor supply, and hence the greater the excess burden of income taxes.
To reduce distortions, broader and flatter taxes are better because then marginal tax rates are lower. Rudy Giuliani has proposed a flat and rather broad income tax with a highest marginal tax rate of only 30 percent to complement the present complicated income tax system. Consumption taxes, such as value added taxes, have lower excess burdens than income taxes. Like an income tax, a general tax on consumption does discourage work in favor of leisure essentially because individuals can avoid both consumption and income taxes by taking additional leisure since leisure is not taxed. However, an income tax has other distortions as well since income is both taxed when received, and also taxed again when the savings out of income produces additional income. Income taxes in effect tax savings twice, while consumption taxes only tax savings once, when they are spent. In order to reduce this double taxation of savings from income taxes, the US and other countries allow families to save in ways that are free of income taxes until the savings are spent, such as through saving with IRAs.
There is a natural tendency to assume that the burden of taxes falls on persons or companies that mail the tax checks into the government. To show why this is generally false, consider a 10 percent tax on capital that initially reduces returns on capital from say 8 percent to 7.2 percent. This initial impact is clearly on owners of this capital, who are generally wealthier than the average individual. Over time, however, the capital stock would fall because companies reduce their investments in reaction to the lowering of after-tax returns on investments due to the capital tax. As the capital stock falls, the after-tax return would begin to increase because the productivity of capital is higher when capital is scarcer relative to labor. The capital stock would continue to fall essentially until after-tax returns climb back up to the 8 percent level they were at before the tax on capital was imposed.
Since studies confirm that in the long run owners of capital get about the same rate of return that they would have without any taxes on capital, who then pays the capital tax in the long run? The answer is not capital but labor because wages and earnings are lower when workers have less capital to work with. Owners of capital continue to send in the checks to pay a capital tax, but the negative response of investments to a capital tax shifts the burden of a capital tax away from capital to labor. That eventually labor pays a tax on capital even though it is placed on capital explains why economists generally oppose long-term taxes on capital even though in the short run capital taxes have many desirable properties. Investment tax credits, accelerated depreciation, and low taxes on capital gains are some of the ways that the effective long run tax on capital is reduced toward zero.